Trump’s Spending Splurge Is a Long-Run Recipe for Higher Taxes and Less Prosperity

Trump and his allies in Congress recently agreed on a big-spending budget deal that lavishes more money on both the Pentagon and domestic programs, and that was only a few weeks after agreeing on a tax reform plan that lower taxes (though only for nine years).

In a column for the Wall Street Journal, Professor Edward Lazear of Stanford explores the economic damage of ever-expanding government.

The budget deal President Trump signed earlier this month will send federal spending and the deficit skyrocketing. On top of this spending explosion, the administration now plans to add a $500 billion infrastructure bill. …over time high spending necessitates high taxes, and high taxes reduce work and restrain growth. Economic trends in developed nations consistently show that low taxes and hard work are linked to robust growth.

He looks at some of the cross-country evidence.

European countries trail the U.S. in working hard and controlling taxes, and their economies have lagged in comparison. France has a tax-to-GDP ratio of about 44%, and in Italy it’s 43%. The French and Italians work almost 30% fewer hours per person than Americans. Notably, the French economy has flatlined since 2010 while Italy’s has contracted. …Data from the Organization for Economic Cooperation and Development suggests that a 1% increase in a nation’s tax rate is associated with a 1.4% decrease in hours worked per person in the working-age population.

Here’s the part that resonated with me. It’s excessive spending that ultimately is the problem.

…taxes are ultimately dictated by spending. Countries can borrow to finance short-run spending, but they must eventually levy taxes to repay the loans. Whether a government raises taxes now or later to pay for expenditures is a minor consideration compared with its decision to spend in the first place. …Higher spending goes hand in hand with higher taxes, higher deficits, fewer worked hours and less growth. The international comparisons suggest that a 4% increase in spending is associated with a decrease of roughly 0.5 percentage point in the average annual growth rate. Furthermore, it is spending—rather than the deficit—that correlates with sluggish growth. …Deficits often coincide with low growth because deficit increases are usually caused by heightened spending, not reduced taxes. Raising taxes, or keeping them high without lowering spending, stifles growth.

Heck, even the OECD has produced research on the negative impact of government spending on economic performance.

And this approach can lead to a downward spiral.

To the extent that government spending goes to programs such as welfare that directly discourage work, it has an additional growth-reducing effect. When fewer people work, those who do must be taxed even more to cover public expenses. These heightened taxes on labor discourage work in turn, pushing more potential workers toward government support.

Since we’re on the topic, let’s look at some additional evidence. Three economists from Australia and the United Kingdom did a meta-analysis of studies on the relationship between government spending and economic growth. Here are some of the findings.

One of the most contentious issues in economics is whether ‘big government’ is good or bad for economic growth. …Theoretically, big government can have both negative and positive effects on growth. …In this study, we include all effect-size estimates reported by empirical studies that examine the direct effect of government size on growth.

Here’s what they found.

… findings indicate that: (i) total government expenditures have a medium and adverse effect on per-capita income growth in developed countries only; (ii) the effect of government consumption on per-capita income growth is also medium in developed countries and in developed and LDCs pooled together; and (iii) neither total expenditures nor government consumption has a significant effect on per-capita income growth in LDCs.

I’m not surprised that they didn’t find a strong link in poor nations. The data show that those countries are generally too mismanaged and corrupt to collect much revenue. Therefore, as I noted in my recent analysis of Indian economic policy, they can’t spend much.

What’s primarily holding back those countries is weak rule of law, excessive regulation, and protectionism.

But I’m digressing. The study also acknowledges the Rahn Curve, though they call it the Armey Curve.

…government size tends to have a negative effect on per-capita income growth as the level of income increases. This finding ties in with the Armey curve hypothesis (Armey, 1995), which posits an inverted-U relationship between government size and economic growth. The theoretical argument here is that government size may be characterised by decreasing returns. Another theoretical argument relates to the distortionary nature of taxes, which is minimal for low levels of taxation, but beyond a certain threshold, they grow rapidly and become extremely large.

Quite true.

Sadly, some people mistakenly conclude that if a little bit of government is associated with more prosperity, then a bloated public sector must be even better.

Why are Western countries like the United States and Germany so much richer today than other countries around the world? …One explanation for the success of the West is, in a word, liberty. Over the last few hundred years, classical liberal ideas such as the rights of man and the rule of lawput constraints on European governments’ power, which resulted in a strong protection of private property rights. This resulted in meteoric economic growth, which delivered the modern cornucopia of wealth. …Free countries get rich; unfree countries stay poor.

But there’s a competing theory.

…another explanation — state capacity…is the idea that economic development requires strong, centralized states to uphold the rule of law and provide crucial public goods. …The state capacity literature in economics…places heavy emphasis on a single, strong, central legal authority. In this framework, the fractured and decentralized legal authorities in medieval and early modern Europe are now seen as antithetical to economic development.

Salter is skeptical of the second theory.

…it is undeniable that economic growth in the West did not take off until the rise of modern nation-states. … While governance institutions obviously began centralizing at the beginning of the modern era, …that’s insufficient as a causal explanation. …the state capacity literature has a hard time dealing with a very troubling counterexample: the totalitarian states of the 20th century: like the USSR and China. These states had plenty of capacity, as evidenced by their ability to murder millions of their own citizens… Needless to say, these kinds of things aren’t conducive to economic development.

So he concludes that the first theory must be the answer, at least in part.

…whatever is “doing the work” of promoting economic growth, it is upstream of the creation of states. …State capacity may or may not be a valuable steppingstone to an explanation, but it is not itself an explanation that social scientists should accept. …it seems the old hypothesis — that the big ideas of classical liberalism created Western economic growth — is worth another look!

My bottom line, for what it’s worth, is that the classical-liberalism approach is the necessary condition, but that doesn’t automatically make it a sufficient condition.

In a column last year on the emerging micro-state of Liberland, I tried to square the circle. Here’s some of what I wrote after looking at the literature on state capacity.

…the key to prosperity is having a state strong enough and effective enough to provide rule of law, but to somehow constrain that state so that it doesn’t venture into destructive redistribution policies. This is why competition between governments played a key role in the economic development of the western world. When governments have to worry about productive resources escaping, that forces them to focus on things that help an economy (i.e., rule of law) while minimizing the policies that hinder prosperity (i.e., high taxes and spending). …America’s Founding Fathers dealt with the same issues… Their solution was a constitution that explicitly limited the size and scope of the federal government. …that system worked reasonably well until the 1930s.

I find this issue fascinating, but I suspect most people are more concerned about the real-world consequences rather than the theoretical underpinnings.

[…] that occurred when the Tea Party had some influence, the budget news has been bad. Trump is totally unserious about controlling the burden of government spending and even routinely rolls over for new increases […]

[…] The same people also claim that at least Republicans will hold the line on taxes. I think they’re hallucinating. If we don’t get control of spending, sooner or later we’ll get massive tax hikes. […]

[…] taxation by states. Fortunately, that didn’t happen. So the “omnibus” plan is a pork-filled affront to fiscal sanity, but at least it’s not a state-goverment-empowering, pork-filled affront to fiscal […]

The real conundrum for me is… yes, of course, government spending needs to be curtailed. However, the flow on benefits from this policy (which is the only fundamentally sustainable course) are not instantly felt by voters, in fact the voters usually feel a little pain at the time. In this age of short-sightedness it is very difficult to implement these policies & get re-elected. Now, more than ever in history, there is far greater & immediate weight on the cultural consequences that the attitude held by those in power has on the country. This needs to be taken into consideration, economics cannot stand alone anymore, society has morphed into cultural mindsets that drive economic policy. In this light, I ask the question: Are we better off having a big spending, low taxation, re-electable Trump in power & at least getting some great policies + winning many battles in the culture wars…. vs another Obama-style president from the Dems?

I guess the question is Dan, how do you recommend a President successfully prosecute the case for spending cuts in this age with a serious chance of being re-elected & remaining popular in the short-term?

Indeed, without spending reform, tax reform will only have a modest impact and will simply kick the can of big government down the road, where it will eventually (soon) be picked up by a Bernie Sanders who will finally make everybody pay their big fare share for his wonderful big government society, where effort-reward curves will be flatter…and life will be easier, of course. His society that follows many other societies in elevating perceived societal good above the aspirations and freedoms of the individual — and thus achieve neither personal nor societal aspirations, freedoms — and especially prosperity!

But the audience for this criticism is not Trump, but rather voters themselves. Of course, bloggers who do eponymous work and appear in public (yes even those who work for the Cato institute) have to be diplomatic in their criticism and avoid directly criticizing and thus offending their very audiences. Hence they typically prefer to criticize politicians rather than the voters who elect them, for understandable tactical and self preservation reasons. Fair enough, often criticism of a politician can be construed as indirect criticism of his/her voters.

But in order to help restoring balance towards assigning blame where it really belongs, let me help out a bit, as an anonymous commenter who has no audience to kiss up to:

One of the main reasons that Trump cannot reduce government spending is that voters do not want him to. American voters have jumped the shark. They are on trajectory to undo all the unique features that set this country apart from the rest of the world and thus — consequently and more importantly — are on firm trajectory to become citizens of a slow growth big government European like nation — where world average prosperity will catch up to them by 2050-60. Essentially, on current trajectory, Americans will be middle income world citizens by 2060 — a middle income nation. That is the essential trajectory that the American voter-lemming is driving his country towards.

So what is the fundamental driver of such seemingly innate voter behavior? The driver is that a redistribution dollar today is worth ten promised perpetually compounding growth dollars in the future. The voter intuitively understands that all government spending is essentially redistribution that flattens the effort-reward curve. They understand that they too will have to pay to support big redistributive government, but also think that the burden of payment will fall primarily on others.

The voter-lemming understands all that. What he cannot grasp is exponential growth, or lack thereof. He does not understand how quickly the subpar growth of flatter effort-reward curves compounds a country into mediocrity, especially in our age where world growth, as well as everything human, is irreversibly accelerating. Gone are the days of the sleepy slow growth world where cans could be kicked down the road to future generations. The seemingly easier and more comfortable life of a flatter effort-reward society will come to directly haunt those who supported it in the first place.

Hence, by virtue of the law of probabilities, at the personal level, take my advice and stay mobile. The chance that your country will be in the small group that serendipitously escapes the primal instincts of the voter lemming …are small. Better hedge your bets by staying mobile. I know that this is easier said than done, especially for the majority of Americans who (unlike me) were born in this country, have deep roots here, and are generally unaware of how quickly this country is ideologically and self-destructively aligning with the rest of the world. But those Americans who care about the future of their families must take action to stay mobile. What is at stake at the personal level is nothing else than leaving your children to live in a future middle income country. Of course, much better than today in any case, but a middle income country nonetheless by the much elevated standards of AD 2060.

P.S. The real debt limit is when investors throughout the world start questioning whether the US can indeed repay all its loans, current and future, while still maintaining enough motivation and a steep enough effort-reward curve to at least keep up with average world growth. That point of doubt may be closer than we realize. The saddest and most destructive part is that this is exactly when the knee jerk reaction of American voter-lemming said will blame low taxes rather than spending and will elect a Bernie Sanders, thus cementing the unprecedented crisis into a permanent structural decline.

PPS. The outcome will be worse than Greece during its immediate post crisis acute phase. Because of the simple fact that there is no entity on earth that can soften the fall of a crumbling US behemoth. That may force some real reforms (unlike Greece) by my guess is that it will likely cause an even faster structural transition towards Venezualization under a Bernie Danders who told us all along that taxes were too low. The world has entered an irreversible, and never seen before in the history of civilization, fast growth. We will thus see things that we never thought were possible. This even faster American decline scenario may be one if them.

PPPS. The reason we get bad policy from Democrats and worse from Republicans is that spendthrift politicians (yes I admit politicians are even more spendthrift than voters but it’s voters who are responsible in the end) is that Democrats while in office have at least an ideological spending restraint from Republicans. When Republicans are in office, and thus can act out their true political interests of bigger government, then they have NO spending restraint opposition in any chamber. A politician who acts to decrease government is a politician who acts towards shrinking his/her own profession. Who acts like that in their own professions? If voters do not restrain spending the result is obvious.

The America I knew is long dead and buried. Why carry on the charade that there is anything left worth worrying about or preserving. In a nation where Tide pod eaters lecture us and are taken seriously by the media what can one say about our grounding?

In a nation that heeds the cries of illegals more than it cares and protects it citizens can we doubt that citizenship means nothing?

In a time when felons, illegals, the dead, and the insane are registered to vote by one party, who can take democracy seriously.

In a judicial system where a law means what each judge believes or hopes it means, and where that meaning changes with each day, who can rely or believe in the law?

C’mon folks the system is dead. The sooner we burn it down along with those who brought us to this moment the sooner we can restore America. It may be smaller, it will not be as diverse, it won’t be “tolerant” in the terms we are forced to shallow today, but it would be a nation the Founding Fathers would recognize.